12816353 Opportunistic Investing Real Estate Private Equity Funds

RE A L ES TAT E, HO S P I TA L I T Y,A N D CO N S T R U C T I O N

Opportunistic Investing: Real Estate PrivateEquity Funds

OP P O RT U N I S T I C IN V E S T I N G: RE A L ES TAT E PR I VAT E EQ U I T Y FU N D S

Over the last decade, the real estate private equity fund sector has flourished. Real estate value added and opportunity funds areperhaps the most prominent vehicles in this sector. The first of these opportunistic real estate private equity funds were raised in thelate 1980s/early 1990s to capitalize on the opportunities resulting from the sudden unavailability of debt capital and the abundance ofavailable product offered by motivated sellers, most notably the Resolution Trust Company. Since that time, the number of funds hasgrown and their underlying investments have become increasingly more complex and global in address. Originally perceived asfinite-life investment vehicles, these funds have arguably become viable, infinite-life businesses able to support the operatingorganizations built to manage them.

One factor supporting the proliferation of funds is the closer alignment of investor and General Partner interests. Historically,advisors/managers were hired to invest money on behalf of institutional investors, and were compensated based on the appraisedvalue of the investments; they had no equity of their own in the investments. This misalignment of interests between the investorsand the advisors became glaring as real estate values decreased in the late 1980s. Today’s real estate private equity fund structureprovides better alignment of General and Limited Partner interests because the General Partners have equity, sometimes significantequity, invested in the funds, and participate in realized gains as opposed to paper gains.

Other factors helping to fuel this rapidly growing sector include the success of most of the early vintage year funds, the continuingavailability of equity coupled with a skyrocketing stock market, and expanding global opportunities. These factors have enhanced thegrowth of the sector, not only in terms of the huge amount of money raised, but also in terms of the number of funds now operatingglobally. We believe there are now more than 100 Fund General Partners throughout the world.

Opportunistic real estate private equity funds are flush with capital as we enter 2002. If the sentiments voiced by fund GeneralPartners in our recent survey are on target, they are poised to capitalize on new opportunities in this ever-changing world. In fact,based on our survey results, a minimum of $20 billion of equity remains to be deployed. Further, according to our estimates based onsurvey responses and information available publicly, in excess of $90 billion in equity has been raised for opportunistic investing inreal estate since 1991. Impute leverage of 60% to these amounts and one can appreciate the significance of this sector of the industry.

More recently, the trend among these funds has been to raise larger funds and to refinance existing assets to repatriate capital. Inaddition, a substantial period of real estate market equilibrium has slowed the pace of transactions domestically, increased the bid/askspreads on properties, and has driven funds to deploy capital outside the U.S.

At this point in their evolution, opportunistic real estate private equity funds are under increased scrutiny from investors seekinggreater transparency and standardization in reporting information. We believe 2002 will be a watershed year in which great stridesare made in these areas. The recent changes to the AICPA Audit and Accounting Guide for Audits of Investment Companies withrespect to the disclosure of financial highlights should help in this regard. Through our survey we tested the General Partners’ pulseon the subjects of financial reporting and performance reporting. We considered the various and complex tax issues which GeneralPartners must navigate to achieve targeted yields. We also surveyed the use of technology throughout the funds' value chain as a toolto facilitate global communication, reduce costs, and create better efficiencies.

Of course, it remains to be seen what impact the global recession, rising security and insurance costs, and the ability to secureterrorist coverage will have on the industry and on fund returns. The events of September 11 will certainly have profound impactson the real estate industry and in the process create new opportunities as well as new challenges.

We’d like to thank the funds that participated in our survey. We hope you find the discussion here insightful as we look at thecomposition of this exciting sector and the complexities that need to be addressed if the various players are going to continue to findsuccess.

Dale Anne ReissGlobal Industry Leader,Real Estate, Hospitality, and Construction Group

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About the Survey ProcessWe embarked on a survey of opportunistic real estateprivate equity funds to enhance the industry’sknowledge, as well as our own, of what we have seenas a large and growing sector. The survey, whichincluded approximately 150 questions covering manysubjects, including financial and performancereporting, taxes, and infrastructure and technology, wassent to more than 100 fund General Partners, ManagingMembers, and/or Managers (collectively, “GeneralPartners”). We received 48 responses. Not allrespondents answered every question, and certainresponses were supplemented with informationgathered in personal interviews with the GeneralPartners. In total, our participants represent $72.3billion of equity raised in 145 separate funds between1988 and 2001.

Ernst & Young has maintained the confidentiality of allresponses and respondents. Under no circumstanceswill the identity of the respondents be revealed to thepublic or the other respondents.

In preparing this report, Ernst & Young relied on thedata and information supplied by the respondents. Wedid not attempt to verify the responses provided by therespondents, and we do not take responsibility for theaccuracy or reliability of the data.

Cumulative Fund Equity Raised (by year)

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Overview of Major FindingsOpportunistic real estate private equityfunds are also known as “value-added”funds and “opportunity” funds. By

atever name they are known, their success stems frome ability of savvy General Partners to locate andpitalize on over-discounted risk or overlooked valuehancement opportunities. Similar to more traditionalivate equity funds (i.e., venture capital and buyoutnds), these real estate funds target higher yielding (15%-us leveraged) private investments. In addition, theypically have an average life of from seven to 10 years,ten with two one-year extensions. Generally, theyovide for a 1% to 2% annual management fee, a 20%rried interest to the General Partner after achievement ofreferred return hurdle (typically 9% to 10%) and have anificant individual, pension fund, and endowment

vestor base. The General Partners (and their affiliates)pically commit 1% to 5% of the fund capital, butmmitments of those General Partners (and theirfiliates) associated with investment banks often rangetween 2% and 40%. Modern day opportunistic realtate private equity funds originated in the early 1990sth a proliferation in the number of General Partneronsors beginning in 1997.

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2 OP P O RT U N I S T I C IN V E S T I N G: RE A L ES TAT E PR I VAT E EQ U I T Y FU N D S

For this reason, and given the 10-year-plus all-in potentiallife of these funds, the track record for this sector remainsa work in-progress.

According to our survey results, individual funds haveraised capital in varying amounts, ranging from $22 million to in excess of $3 billion. However, only 11General Partners commanded equity in excess of $1 billion for a single fund.

Fund Equity Raised (by number of funds)

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Our survey revealed that a relatively small percentage ofGeneral Partners control a large percentage of the capital.An estimated 13 fund General Partners represent 70% ofthe estimated equity raised. The average individual fundsize for these 13 large fund General Partners is $957million of equity, or almost four times the average size ofthe other 35 respondents ($242 million of equity). Themajority of the larger fund General Partners are real estateinvesting arms of larger private equity groups, whether themerchant banking arms of investment banks or stand-aloneprivate equity firms.

Since the early 1990s, the amount of capital earmarked oreligible for investment outside the U.S. has graduallyincreased, with in excess of 60% of the current outstandingand committed capital available for non-U.S. investment.Individual investments run a broad gamut and take manyforms, as General Partners structure transactions inresponse to the often-unique conditions of eachopportunity.

Average investment holding periods were generallyreported to be four years, a period which could bereflective of the complexity of investments and theslowing economy.

Our survey respondents reported raising an aggregateamount in excess of $17 billion of new equity during 2001,

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Total Fund Equity Raised (by year)

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with $20 billion of total equity available for investment.Considering that typical leverage applied to theirinvestments is between 60% and 70%, funds are currentlyholding more than $50 billion in investment potential.

Based on our discussions with General Partners, recentcapital raising efforts are taking two to three times longerthan anticipated. General Partners also report a slowingpace of equity deployment in 2000 and 2001, as thepricing available in the market generally did not supporttargeted fund yields.

The growth in opportunistic real estate private equity fundsand the changes that accompany a decade of history haveled to a greater focus by the General Partners on some ofthe management and operating basics. Discussions withGeneral Partners and survey responses identified a numberof non-transactional issues that are receiving a great dealof attention.

One issue that is of great importance to the respondents isfinancial and performance reporting. As this sector of theindustry has grown, interest has heightened regarding thevaried reporting practices and methodologies employed byreal estate private equity funds. Our survey identified threedistinct methods of financial statement reporting (i.e.,historical cost, income tax, and fair value), with theoverwhelming majority reporting in accordance with fair

value. Our respondents also reported using many differentmethods to determine fair value.

Another area of focus is the efficiency of the funds’ taxstructure. Many funds indicated that they are using specialtax structures (i.e., blockers) to minimize unrelatedbusiness income tax (UBIT) for tax-exempt investors andare developing procedures to monitor UBIT issues andavoid UBIT traps throughout the life of the fund. Funds arealso looking for efficient structures to minimize foreigntaxes, foreign tax withholdings for U.S. investors and U.S.taxes for both domestic and foreign investors. Funds alsoreported that they are looking for ways to insure that thepartners’ relative capital accounts (after allocation ofincome and loss) are in accordance with the intended cashwaterfall distributions, including efficiently designingpartnership agreements and developing procedures foreffective monitoring.

Yet another important concern for these funds is theinvestigation of ways to streamline processes andtransform their businesses to make them technologicallyefficient and reduce costs. By maximizing the efficiency offund processes and procedures, and thereby reducing costs,the yield to investors can be increased. Some of the biggestobstacles facing these organizations include a lack ofcommunication between departments, currency, language,cultural and time-zone differences, and lack of standard-

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Capital Remaining to Invest (by year)

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Method of Financial Statement Reporting (by number of respondents)

ized procedures and processes. Advances in technologycan enable the General Partner to overcome many of thesissues.

This white paper describes many of these issues in moredetail and provides commentary based on our surveyresponses as well as our knowledge of the industry.


Financial andPerformance Reporting IssuesOur survey asked a series of questions

addressing the reporting methodologies and practices ofopportunistic real estate private equity funds. As expected,their accounting and underlying valuation practices are asvaried as the funds themselves.

Survey respondents identified what on the surface wouldappear to be three different (but basic) accounting andreporting methods. Eleven respondents (representing $7.5billion of equity) indicated that they report their financialstatements using only historical cost accounting, and fourrespondents (representing $4.8 billion of equity) said theyreport using income tax basis accounting principles. Theremaining funds said they provide fair value financialstatements. It should be noted that the fair value method ofreporting is consistent with the generally acceptedaccounting principles (GAAP) used by private equityfunds as described in the AICPA Audit and AccountingGuide for Audits of Investment Companies (InvestmentCompany Guide).

With respect to those reporting on fair value, 14 respon-dents (representing $15.2 billion of equity) reported thatthey fully consolidate all controlled investments, and 10respondents (representing $36.3 billion of equity) said theyreport their share of operating earnings and appreciation(depreciation) using the equity method of accounting. Theother seven respondents (representing $8 billion of equity)said they report operating income and expenses andrealized gains and losses only as cash is received (realized)from ventures and otherwise report their pro rata share ofunrealized changes in value. Possible reasons for thisdiversity in reporting methods include that the InvestmentCompany Guide was not written with real estate privateequity funds in mind and, accordingly, industry partici-pants have had to adapt from practices of venture capitaland buyout funds. While each of the aforementioned fairvalue methods result in differing presentations, the bottomline profit and loss results are the same.

Method of Financial Statement Reporting (by equity $’s raised)

Similarly, our respondents reported using an assortment ofmethods in determining “fair value,” which by definition isthe amount at which the investment could be exchanged ina current transaction between willing parties other than ina forced or liquidation sale. Depending upon the subjectasset and extent of its seasoning, some General Partners(29%) reported performing discounted cash flowcalculations to determine fair value. Others (52%) saidthey report increases in value upon the realization ofcertain market events, such as lease-up or the completionof improvements or renovations. Still others (24%)

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indicated they occasionally obtain third party appraisals.Market capitalization rates and the application of amultiple to earnings were also reported as value estimationmethods utilized. Most funds said that declines in value arereported when events indicate that their investments’performance and potential have significantly deteriorated;in other words, as impairment has occurred.

As this sector has grown, interest has heightened regardingthe sector’s varied reporting practices and methodologies.Investors are seeking greater transparency in reportedinformation, a greater ability to measure performance onan interim basis and an ability to benchmark. Unfortu-nately, there is no simple answer. Because of thecomplexity, diversity and dynamic nature of the largenumber of the underlying investments held by oppor-tunistic real estate private equity funds, no “one-size-fits-all” solution may exist.

Examples of fund investments include:

" Private prison operating companies." Raw land development." Pools of non-performing loans." Conversion of empty office properties into residences." Private hotel companies." Technology related private operating companies." Private homebuilders." Preferred stock interests of

public companies.

General Partners indicatedthat in overemphasizing thestandardization of specificquantitative measurements,one runs the very real risk ofnot understanding theseprivate equity vehicles at all.

To a large extent, thevaluation policies employedby the funds have beenadapted from those longpracticed by other alternative private equity investmentfunds. As mentioned earlier, private equity funds presenttheir financial statements on a fair value basis as requiredby the Investment Company Guide. Underlying fundpartnership agreements generally provide the GeneralPartners with the responsibility for determining the fairvalue of portfolio investments. Such valuations may ormay not be subject to approval of a limited partner

advisory committee or similar investment or valuationadvisory group. Usually, their valuation policies recognizethe degree of liquidity (or lack thereof) in fund invest-ments in estimating value. Less liquid private equitysecurity investments generally presume cost as a proxy forvalue, except in instances where significant market eventshave occurred or when there has been an indication of adecline in value.

Opportunistic real estate fund General Partners indicatethat for opportunistic investments, estimating fair value atvarious times during the holding period is much morecomplex and subjective than valuing a stabilized operatingproperty. For one thing, the ultimate realization of value isgreatly dependent on the execution of a value-addedbusiness plan and exit strategy. Exit strategies often areunique to the capabilities and perspective of each fund’sGeneral Partner, and its selection of an operating partner.Value creation is based on a number of variables, includ-ing: timing the markets correctly (including both thecapital markets and local real estate markets); anticipatinglegislative changes; government privatization decisions;finding the right buyers for unique investment types;creatively selling a portfolio to those end-users who findthe assets most valuable; the growth and related success ofnew real estate-aligned technology ventures; and under-standing, supporting and “betting” on emerging markets ora capital markets exit strategy.

The creation of value andvaluation of theseinvestments at most pointsduring the holding period isextremely uncertain. As aresult, many opportunisticreal estate private equityfunds state the fair value oftheir investment at or aboutat cost until a realizationevent occurs or is imminent.This is attributable in part toconservatism on the part ofthe General Partners and a

recognition of uncertainty. Some General Partnersinformed us that where the creation of value is heavilydependent upon execution, they are reluctant to “takecredit” for value before it is realized. The General Partnersworry that overestimating projected results couldjeopardize their credibility with their investors.

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Some General Partners indicated that there are otherqualitative and quantitative communications with investorsthat could assist in monitoring the performance of theirfunds and underlying investments. They question whetherthere are truly negative implications of a conservativevaluation philosophy for certain asset types within a fundthat cannot be mitigated by enhanced disclosures. Theypoint out that opportunistic real estate funds—like otheralternative private equity funds—are limited-lifeinvestment vehicles in which value can only permanentlyinure to the General Partners’ carried interest after therealization of agreed-to preferred internal rates of returns(IRRs) for investors.

There is no doubt that there are inconsistencies in, and, inmany instances, a limit to, the types of information beingprovided to investors. Much of the success of these privatevehicles is dependent upon relationships, execution ofstrategies, and accumulation of knowledge sometimesdeemed proprietary and often deemed a competitiveadvantage.

In the course of our work in this sector of the industry wehave observed numerous fund reports and reportingpractices. Some of the “best practices” we have seen andthat were communicated to us during the survey processinclude:

" Quarterly and annual overviews of investment activityand fund performance." For each fund investment, quarterly and annual

narratives of activity and performance against strategy." For each fund investment, quarterly and annual

summaries of cash inflows and outflows andinvestment vital statistics, including condensedfinancial information. " For each fund investment, quarterly and

annually, the General Partner’s assessment ofwhether the investment is tracking on, below orabove the underwritten IRR, including anarrative description of why." Fund advisory committee approval of asset

valuations.

Adoption of some or all of these practices asappropriate would benefit both investors and theoverall sector as it grapples with the issues oftransparency and standardization. To further assistin this regard is the new year ending December 31,2001 Investment Company Guide disclosurerequirement of a net investment income ratio, an

expense ratio and a total return calculation (FinancialHighlights) for private equity funds.

Given the foregoing, it appears that comparability ofperformance between funds during their terms based solelyon traditional return measurements is both insufficient andimpracticable. Concerning the subject of performancemeasurement, the overwhelming majority of our surveyrespondents view IRR as the most appropriate perform-ance measure. A few respondents went farther, saying thata projected IRR that includes future value for residualwould be a better proxy for interim measurements ofperformance and comparability.

Increasingly, methods for measuring performance arebeing guided by the Association for Investment andManagement Research (AIMR). In accordance with AIMRguidelines, the only performance measure currentlyreported by private equity funds is IRR. Similarly, VentureEconomics, the official database of the leading venturecapital associations, provides for an annual IRRcalculation using actual monthly cash inflows andoutflows to investors and incorporating residual valuesreported in the annual financial statements in itsbenchmarking.

Notably, the total return calculation now required as a partof fund “Financial Highlights” is a time weighted return(TWR). A TWR is determined by calculating the rate ofreturn between two or more periods and multiplying theresults together, then taking the geometric mean of theresults. It is generally considered a poor approximation of

Capital Account Economic Targeting/TrackingTo meet Internal Revenue Service (IRS) safe harbors andavoid, to the greatest extent possible, UBIT, nearly everyfund makes its liquidating distributions in accordance withthe final capital accounts of the partners. Thus, if uponliquidation there is a distortion in the partners’ capitalaccounts caused by improperly allocated tax items(whether by mistake in structure or application, or as resultof an IRS reallocation of tax items), distributions will notbe made in the order originally negotiated in the tieredsystem for cash distributions (called the cash waterfallsection) of the fund’s partnership agreement.

To deal with this problem, the large majority of fundssurveyed are adopting two approaches. They areconsidering instituting procedures that regularly test thepartners’ relative capital accounts (after allocating taxable

the IRR, and as Venture Economics points out, is amisnomer because the calculation does not consider thetime value of money, but instead produces a return thatdoes not penalize fund managers for timing decisions. TheTWR calculation treats a dollar distributed today the sameas a dollar distributed nine years ago. Time weighting wascreated to overcome instances where a manager had nocontrol over the timing of cash into or out of their manage-ment, which is clearly not the case with real estate privateequity funds.

Many survey respondents reported it was for these reasonsthat General Partners have not calculated TWRs, and thosethat do give the exercise little (if any) weight. For thisreason, we would expect that the required FinancialHighlights will be supplemented with other measures anddisclosures.

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Tax IssuesIn their continued development, fundsalso face significant tax issues. Basedon our survey and interviews with somerespondents, we identified several key

tax-related concerns facing opportunistic real estate privateequity funds as they deal with the numerous challenges ofmeeting their yield targets. Generally, their tax goals are:

" To ensure there are no differences between the intendedand actual cash distributions to investors or the GeneralPartner caused by distorted tax capital accounts. " To minimize the General Partner’s current taxable

income allocations." To minimize UBIT for tax-exempt investors, foreign

taxes and withholding on the fund’s offshoreinvestments, and U.S. tax liability for the taxableinvestors." To maximize the General Partner’s flexibility to

structure investments for taxable investors." To coordinate tax planning and structuring with tax

compliance functions." To arrange for state-of-the-art local partner tax deferral

planning to facilitate property acquisition. " To review internal General Partner documentation

regarding tax (and business) efficient incentives,benefits and vesting within the General Partner group,and effective internal clawback (and related breachremedy) provisions where such payments are required tobe made by the General Partner group to the fund.

income and loss) against the intended waterfalldistributions. They are also adopting foolproof savingsclauses in their partnership agreements that both satisfy theIRS safe harbors for tax allocations and ensure that taxallocations will produce correct economic capital accountsthat will follow the intended cash waterfall distributions.

General Partner Income Allocations and DistributionsA similar capital account problem results from thepotential operation of the clawback in the 72% ofresponding funds which allow the General Partner toreceive interim distributions of “promote” before repayingto investors all of the investors’ capital and unpaidcumulative return thereon.

A clawback is the amount which the General Partner mustreturn to the fund for redistribution to investors if the funddoes not perform as expected, and a promote is thepercentage of earnings exceeding the General Partner’spercentage of capital contributions that the General Partnerreceives should the fund perform as or better thanexpected.

A General Partner’s capital account is potentially distorted(too high) to the degree that they are allocated incomeattributable to promote distributions that are subject toclawback. To the extent the promote is deemed repayableunder IRS rules, however, the promote payment is moreakin to a loan than a distribution when it is received for taxpurposes and no income should yet be allocated to theGeneral Partner. Consequently, a number of respondentsindicated informally that they are reviewing taxableincome allocations to General Partners in order todetermine whether income should instead continue to be

TA X IS S U E S


allocated to the investors in the capital percentages (asopposed to allocating income to the General Partner in ahigher percentage to the extent it has received promotedistributions).

The funds surveyed were divided on several timing anddistribution issues:

"When the General Partner receives its promote inrelation to the return of investor capital and preferredreturn."When, and to what extent, the General Partner is subject

to clawback provisions. " The method of handling the General Partner’s tax issues

resulting from being allocated taxable income fromoperations or upon the sale of a property but receivingno actual cash because cash has to be paid to investorsto satisfy investor IRR preferences." How to handle interim promote funds.

Most funds track contributions, distributions, and taxallocations on an investment-by-investment basis. Thismeans the General Partner is allowed to receive promotedistributions from the sale of a fund investment afterinvestors have received their capital (and promised returnthereon) allocated to only that property, even if theinvestors’ capital (and return) on other properties are stilloutstanding (Interim Promote Funds). In contrast, a few ofthe funds surveyed were “fully pooled,” meaning that allof the investors’ capital and unrepaid cumulative returnmust be paid before any distributions can be made to theGeneral Partner.

One fund has a uniquestructure under whichcash flow is distributed90% to the limitedpartners and 10% to theGeneral Partner (with-out any preference forunpaid capital orcumulative returns) andupon the sale orrefinancing, proceedsfirst repay investorcapital (without afurther preference forany cumulative return)and then are allocated90% to the limitedpartners and 10% to the

General Partner. The balance of the funds were either“Interim Promote Funds” or “Fully Pooled Funds.”

In addition, each fund which allowed for interim promotehad at least one of the following clawback mechanisms toprotect investors against situations in which, uponliquidation, the General Partner could have receiveddistributions in the promote percentage from someinvestments while the investors achieved less than aspecified compounded return on their capital in other fundinvestments:

" The General Partner is required to place a percentage ofpromote distributions in escrow (generally after-tax)." The General Partner is required to post a letter of credit

for a portion of promote distributions." Other distributions to the General Partner are reallocated

to investors as necessary to satisfy the deficient return toinvestors on an aggregate basis through liquidation.

Concerning phantom income (i.e., when income isallocated, but no corresponding cash is distributed to thepartners), 62% of the responding funds reported that theirpartnership agreements provide for relief for the GeneralPartner against their phantom income problems. In mostcases, this involves a reallocation of preferentialdistributions away from investors and to the GeneralPartner as necessary to enable the General Partner to payits taxes on allocated promote income. Otherwise, theGeneral Partner may not receive enough distributions fromthe partnership to pay its taxes. All of these provisionstreat these “tax distributions” as an offset to future promotedistributions to the General Partner. Tax distributions havethe effect of delaying the point at which the GeneralPartner can earn its promote on unsold properties, becauseto the extent money is distributed to pay the GeneralPartner’s taxes, it cannot be used to repay unpaid investorcapital or the accruing cumulative return thereon. As aresult, a General Partner is better off if it delays the timewhen it is allocated taxable income in its promotepercentage than to use tax distributions to pay its taxes.

UBIT RiskUBIT can result from the type of investment (e.g.,condominium or home sales, direct ownership of hotels,interest computed on borrower net profits). But it also canresult when leverage is used in acquiring or improving anequity or debt interest in real estate. UBIT from leveragedequity investments in real estate (as opposed to debtinvestments) can be avoided for pension plans andqualified educational institutions by complex tax allocation

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structuring (and certain related business limitations) thatsatisfy the IRS’s “fractions rule.”

Of the funds surveyed, 89% are allowed to have UBIT. Anumber of funds indicated informally that they obligate theGeneral Partner to use “reasonable efforts” to avoid UBITfor tax-exempt investors, but the General Partner isallowed to incur UBIT if circumstances warrant(however, a few funds have actually guaranteed noUBIT to one or more investors). Some funds wentfurther to protect the sponsor against disputesarising under the partnership agreement’sreasonable efforts rule by clearly stating whichinvestments are permitted to be acquired despitegenerating UBIT.

Most funds also require either attorney oraccountant UBIT due diligence in the initialacquisition stage, and many have adopted ongoingUBIT monitoring programs (20% using internalemployees only, 28% by attorneys or accountants,and 52% using a combination of internal andexternal resources). Perhaps surprisingly, many ofthe General Partners do not involve the taxcompliance accountants (tax return preparers) in all of thefund structuring, acquisition and ongoing monitoringstages. Those who involve the tax compliance accountantsat all of these stages do so to avoid a return positionproblem at tax return filing time that could have beensolved when the documents were drafted or particularacquisitions were closed.

The potential for UBIT problems also arises under severalother circumstances:

"When staged admissions are paired with payments toinvestors who were admitted earlier."When management fee discounts are not granted to all

investors."When default buyout redemptions are permitted at a

discount from fair market value."When the other partners receive an increased ownership."When some partners are required to ante up when one or

more other partners default on their capital contributions(squeezedowns)."When clawback payments are received from the General

Partner.

Based on the documents provided or informal conversa-tions, a number of General Partners have either alreadyprovided special procedures for insuring fractions rule

compliance despite these issues or are in the process ofdoing so.

Interestingly, only a few of the existing funds expresslyauthorize the General Partner to structure so as to mini-mize the tax liability of taxable investors. In contrast, anumber of General Partners that had funds in formation

told us they are adopting such provisions for both domesticand international investments on an ongoing basis in theirnew funds.

Ongoing Reviews and MonitoringAll of the funds surveyed report performing UBIT duediligence and monitoring internally. A number of fundshave indicated informally that they also order supplemen-tary external counsel and accountant reviews. Indeed, in anevolving cautionary trend, many funds have adoptedmultiple levels of review, checklists and ongoing moni-toring (both internally at the General Partner level andwith the outside professional firms) to protect againstinadvertent UBIT traps. As noted, a number of GeneralPartners are increasingly involving their tax complianceprofessionals not only in the initial structuring of theirfunds but also in their ongoing business operations toensure that tax judgment calls today do not create unin-tended results or issues later at tax return filing time.

UBIT BlockersThe legal form or structure of the fund itself often canserve to eliminate UBIT, and one or more special entitiesare sometimes used to block the allocation of UBIT to atax-exempt investor.

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Very few of the funds surveyed have actually used anyUBIT blocker structures, and only a handful were fullyaware of the wide variety of blocker structures that areavailable. A number of funds indicated informally thatblockers are becoming particularly important in attractingprivate foundation and public charity investors, and foravoiding UBIT from sale/leaseback investments.

Foreign TaxesSome of the funds surveyed are organized to investexclusively in foreign properties, and a number ofdomestic U.S. funds may invest a portion (rangingbetween 10% and 30%) overseas without investorapproval. The most popular locations include WesternEurope and the Far East/Asia.

A number of funds that invest overseas indicatedinformally that they have the authority to establish tax-efficient co-investment mechanisms and other structuresthat minimize any direct foreign taxes as well as foreignwithholding taxes, and that enable foreigners to invest inthe fund without doing business in the U.S. in a way thatwould subject them to U.S. taxes.

Foreign tax rules are in a constant state of flux as tax lawsin every country continue to evolve in an effort to keep upwith the sophisticated tax planning ideas and structures. InJapan, for example, the “TK” structure utilized by somefunds is under review by Japanese tax authorities, andfunds using this structure face the possibility of large taxassessments. The TK is a contractual agreement with alocal Japanese proprietor that involves the use of fundsprovided by offshore entities, which in some cases pay noJapanese taxes. Fearing substantial exposure for unpaidtaxes, some funds are exploring the use of the TokuteMokuteki Kaisha (TMK) structure, from which dividendsfrom operations paid to investors are subject to a flat 20%withholding tax with the possibility of tax treaty reductionin appropriate cases. The sale profits, if the stock in theTMK is sold, are not subject to Japanese tax under certaintreaties. Recently proposed legislation in Japan, if passed,would make the profit distributions from TK arrangementssubject to a similar 20% withholding tax. If passed, thismay create an alternative to the TMK structure, whichalthough beneficial from a tax perspective, is adminis-tratively difficult to utilize in practice.

Local Partner Tax DeferralA number of the General Partners reported success infinding properties through advisors representing holders ofreal estate who are unable to sell because they face adverse

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ax consequences. One technique being used is a some-hat complicated partnership transaction between the real

state private equity fund and the property owner thatefers any tax liability for the owner, but permits thewner to monetize a substantial portion of the value f the property.

nternal General Partner Tax/Business Planningn response to our request for suggestions for future surveyxploration, several General Partners asked for industryata on:

Vesting within General Partner entities (in both thepromote share and asset management fee entities).Benefit plans for employees, partners, and shareholders.Succession planning at the General Partner. Clawback responsibility, key man insurance and estateplanning.

n discussions with these General Partners and otherurvey participants, most said they are in the process ofxamining (or plan to review) their own internal agree-ents concerning these business, tax, and accounting

ssues as part of their best practices review.

E
S T I N G: RE A L ES TAT E PR I VAT E EQ U I T Y FU N D S
Business TransformationIssuesYet another concern for funds is theongoing need to streamline andstandardize their businesses to remain

ompetitive. Conversations with General Partners andnalysis of the survey data have made it clear that aumber of circumstances are driving the funds to focus on

proving and even re-engineering their infrastructurelatforms (process, technology and organization structure).hief among the factors, of course, is the realization byeneral Partners that opportunistic investing is an on-oing business, not just an “opportunity” with a two-to-ree-year window. But other factors are also at work.unds are investing in a wider array of real estate usingcreasingly complex arrangements. At the same time,vestors are calling for greater standardization ineasures of performance. Also, General Partners areying to deliver more cost-effective returns by usingftware technology that was not available just a few

ears ago.

f all the factors compelling funds to improve theirusiness processes, a number of General Partners have

information between time zones and global offices.Fortunately, there now are a number of technology toolsavailable that will improve this important but often-overlooked business function.

" FUND STRUCTURES. International transactions areperplexing enough on their own, but when the fundstructure itself becomes complex, perhaps as a result ofmultiple closings and currencies that, in effect, becomea number of “funds” within a fund, the stress placed onthe back office increases significantly. Generally, themore flexible the fund structure is for the General Part-ner and investors, the more difficult and expensive it is to support.

"MIDDLE-TIER ENTITY OPERATIONS. Most global fundsinvesting in Asia use middle-tier entity structures for taxpurposes. From an operational perspective, however,these entities often are inadequate and place the fund atrisk of not meeting some tax requirements. This isparticularly important given the aforementionedchallenges by Japanese taxing authorities. If approachedcorrectly, middle-tier operations can provide real valueto the back office and infrastructure. In addition tomeeting substance requirements, they can provide backoffice support for Asian or European operations, andprovide an internal central point for fund transfers andcash management.

" BUSINESS PLANS AND BUDGETING. Although most of thefunds surveyed develop business plans, their use as amanagement tool varies widely, as does the processdeployed to developthem. For the mostpart, it is an arduoustask, with few toolsother than an Excelspreadsheet that isrecreated each year.Consequently, theprocess usually takesanywhere from 90 to150 days, but withlittle connection to theoriginal pro forma orprior year’s plan. Thefund’s budgeting plan,which should require aroll-up of the businessplans, varies evenmore so from fund to

11

indicated that none has a greater impact than the global-ization of the industry.

For a global fund, manually intensive business processeswith a spreadsheet and general ledger do not make thegrade.

As if the creation of value through the flow and sharing ofinformation from the acquisition team to asset managers,finance and operations departments, and accounting andtax issues isn’t complicated enough, it becomes even moreso in a global environment. General Partners must deal notonly with currency, language, cultural, and time-zonedifferences, but the range of government regulations andtax implications that exist from one country to the next,creating structuring and reporting issues that purelydomestic funds do not face. Consequently, it is anenvironment which requires a well-defined organizationalstructure with clear roles and responsibilities as well asstandardized procedures and processes that are supportedby technology.

InfrastructureAs businesses without boundaries, many surveyrespondents are finding it imperative that their processes,technology, and responsibilities are well thought-out anddefined, automated to the greatest extent possible, andintegrated and understood throughout the entire globalorganization. In reaching these goals, funds have tosurmount a number of challenges:

" DATA FLOW. Survey respondents have indicatedinformally that there is often a disconnect in the flow ofinformation between functions and/or departments, andit is a problem that is greatly magnified in globalorganizations. In closing a deal, it is more common thannot that the most complex details of the transaction arenot sufficiently or efficiently communicated to the backoffice, especially for accounting, reporting, and taxpurposes, resulting in larger cycle times, greater costs,and the increased likelihood of compromised dataflowing throughout the value chain. In many instances,the underwriting model is not updated for final dealterms nor is it used as a management tool to monitorasset performance going forward.

" DOCUMENT MANAGEMENT. The complexity of thestructures and tax requirements result in significantdocumentation. But it is the management of thesedocuments rather than the papers themselves that cangreatly aid in knowledge sharing and the flow of

BU S I N E S S TR A N S F O R M AT I O N IS S U E S


fund. While most General Partners go through theprocess, rarely is it used to manage the funds. Thebudgeting process also takes anywhere from 120 to 150days as well as a significant commitment of resources.We believe that for most funds the budgeting processneeds improvement.

" CASH MANAGEMENT. The transfer of funds is normally arather routine operation. But in a global framework thisrelatively simple task faces its own set of uniquechallenges. For one thing, there is usually a multitude ofparties involved in crossing time zones. Ensuring anadequate audit trail and flow of funds through thevarious legal structures can also be challenging. If nothandled properly, they risk compromising the benefits ofthe tax structure. In addition, funds operating globallyneed to deal with currency hedging issues, systems andreporting to maximize return to investors, eliminateconfusion and avoid having a sound real estate invest-ment turn into a money losing proposition because ofcurrency fluctuation.

" INTER-OFFICE AND JOINT VENTURE COMMUNICATIONS. Contactbetween headquarters, regional offices and joint venturepartners is frequently inefficient at best, and dangerousat worst. Some funds use the Internet to communicate.But they have no T1 or VPN lines to transmitconfidential information, so basic security precautionsare non-existent. Even when funds have the facility tocommunicate and transfer information between officesand partners, they tend to lack a standardizedcommunications and reporting process. Many times,there is little or no regular schedule for reports, nospecified format, no protocols. And as a result, much ofthe work must be redone, reformatted or manipulated atheadquarters to fit the necessary information parameters.

Systems IntegrationIf for no other reason than to eliminate duplicate entry ofdata, system integration is one aspect of the businessprocess that can provide direct benefits. The goal is toobtain current and accurate information. For example,when a loan payment such as proceeds from the sale of anasset is received at the fund’s banking institution, a goodsystem will instantly update the fund’s asset managementdatabase which interfaces with the general ledger databaseso that up-to-the-minute financial and performance reportscan be generated.

Unfortunately, the most basic type of integration acrossmultiple systems does not appear to exist in the world of

real estate private equity funds. The reason may be some-thing as simple as coding references that differ from onesystem to another. But whatever the cause, without anydegree of commonality, our survey found that the majorityof funds are transferring data by e-mail, fax, or diskette.Repetitive data entry and a compromise in the integrity ofthat data is the result.

Utilizing a Database?

Another recurring challenge facing funds is the wide rangeof technological capabilities that exist at the variousoperational levels. This includes not only the in-placeinfrastructure in a foreign country, but also the analyticaltools employed for financial modeling and sensitivityanalysis at the home office.

The concept of document or content management is onewith which nearly all funds are wrestling. The ability toscan, index, store, and quickly retrieve the content associ-ated with a part of the business process is not one that evenmany of the business’s leaders possess. Thus, getting to thepoint in which closing documents, operating systems, andloan servicing data is available for the entire portfolioseems a long way off.

In addition, while most funds maintain some semblance ofan investor relations database, few actually have adopted

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the most basic elements of customer relationship manage-ment. They must develop the ability to answer theseessential questions:

"What information should be maintained about eachindividual investor? " Does the same investor invest in multiple funds?"What channel does the investor use to interact with the

fund? "What fund metrics have been communicated in the past

and what metrics should be used in the future? " Has the investor’s position within the fund changed over

time?

Accounting SystemsMany funds have asked which core financial andaccounting systems are used by their colleagues andcompetitors. With a continuing focus of tailored solutionsfor the real estate private equity and pension fund arena,both MRI and Yardi remain the most widely used.

Core Financial Applications

Finally, in reviewing the data presented in the survey,several things become clear. For the most part, the majorglobal funds are focusing on infrastructure and operations.They recognize that the complexities have grown and thatthe risks of a spreadsheet-based environment are simplytoo great. The funds making the greatest strides recognizethat technology is not a silver bullet, but rather a tool toenhance operational efficiency as well as improve internalcontrols. They also recognize the interdependency ofpeople, process, and technology in building their opera-tions, and that often a process is not defined within a singledepartment but crosses numerous functions, from sourcing

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and acquisition to accounting and investor reporting. Torealize the benefits of change in the back office, changesare necessary in the front office, too.

Currently, the greatest opportunity for increased opera-tional efficiency lies in the global operations and theconnectivity of those operations to U.S.-based head-quarters. This is also where the greatest risk exists.Fortunately, many funds recognize this as an area ofvulnerability and are beginning to focus on upgrading theiroperating platforms and infrastructure. Unfortunately, mostare doing so in a manner that is not leveraging off oflessons learned in the more mature U.S. market. Globaloffices are determining their own individual strategieswithout direction from the home office toward a global anduniform solution. Thus, disparate platforms are beingcreated, platforms that, in many cases, do not meet theneeds of either the local or headquarters offices. The resultis a more costly, less efficient and less seamless solutionthan is otherwise possible.

The best in class funds are approaching their infrastructureneeds from a truly global perspective, a position that lever-ages the lessons learned from the matured distressed assetmarket in the U.S. and the technology solutions nowavailable.

13

ConclusionIn a little more than a decade, opportunistic real estateprivate equity funds have become a major component ofthe real estate capital markets in the U.S. and globally.With this global expansion and the gradual maturation ofthis sector has come the type of operational issues andproblems experienced by many industries. GeneralPartners are facing increased pressure to standardizeperformance reporting, create greater transparency infinancial reporting, and develop consistent valuationmethodologies for investments. General Partners operatingthese funds have come to recognize some of the mostcritical issues and are considering ways to improve theirreporting and operations. There are many areas whereGeneral Partners may have an opportunity to drive costsavings, including adopting and integrating technologysolutions and improving global communications andidentifying and implementing appropriate tax structuresand strategies. The real estate private equity fund sectorhas come far in the last decade; but it still has a long wayto go.

www.ey.comER N S T & YO U N G LLP

© 2002 Ernst & Young LLP.All Rights Reserved. Ernst & Young is a registered trademark.

SCORE Retrieval File No. W00269

Ernst & Young has made significant investments in the people, processes, tools, and methodologies required to meet the uniquechallenges faced by real estate private equity funds. Our state-of-the-art solutions incorporate industry leading practices and cutting-edge strategies to address each fund’s critical success factors. Ernst & Young’s Real Estate Private Equity Fund Services Group is anintegrated international team of renowned senior real estate professionals specializing in providing value-added, multi-disciplinaryservices to these funds.

For more information about any of the topics discussed here, please contact one of the Real Estate Private Equity Fund ServicesGroup professionals listed below.

About Ernst & Young’s Real Estate Private Equity Fund Services Group

LESLIE LOFFMAN

National Director, REIT ServicesNew York212-773-1457

SANFORD PRESANT

National Director, Real Estate Private EquityFund ServicesLos Angeles310-551-7805

United States

MICHAEL FRANKEL

National Director, Real Estate Tax ServicesDallas214-969-0632

BRADLEY HALL

National Director, Strategy & BusinessTransformationLos Angeles213-977-3803

DEBORAH LEVINSON

PartnerNew York212-773-4504

Europe

SUSAN CARDEN

PartnerParis33-1-46-93-77-61

DAVID FRIEDLINE

PartnerLondon44-20-7951-5053

RICHARD WHITE

PartnerLondon44-20-7951-4699

Asia

MARK GRINIS

PartnerTokyo81-3-3506-2540

DALE ANNE REISS

Global Industry Leader, Real Estate, Hospitality, and Construction Group212-773-4500

12816353 Opportunistic Investing Real Estate Private Equity Funds

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